First Circuit sides with debtor on finality of 363 sale and challenge to IP distribution rights

Last week, the United States Court of Appeals for the First Circuit affirmed two bankruptcy court decisions implicating two critical Bankruptcy Code provisions that speak directly to a debtor’s ability to maximize the value of asset sales in Chapter 11.

Background

Tempnology LLC (n/k/a Old Cold LLC)[1] was a textile manufacturer who was forced to file for bankruptcy after a long dispute with one of its primary licensees, Mission Product Holdings, Inc. (“Mission”). In the early days of the case, Tempnology established a sales and marketing process for an asset sale under Section 363 of the Bankruptcy Code. Prior to the completion of the sales process, Tempnology rejected its distribution agreement (the “Distribution Agreement”) with Mission. Mission consented to the rejection but preserved its rights under 365(n) of the Bankruptcy Code as a non-debtor licensee of intellectual property. The Distribution Agreement provided Mission with three distinct rights: (i) exclusive distribution rights to certain products within the U.S.; (ii) a non-exclusive, perpetual, royalty free license to exploit certain of Tempnology’s intellectual property; and (iii) a limited, non-exclusive right to use Tempnology’s trademarks. At a hearing on the scope of Mission’s rights under the Distribution Agreement, the Bankruptcy Court confirmed that while Section 365(n) allowed Mission to continue to exercise its right to exploit specific parts of Tempnology’s intellectual property, that provision of the Bankruptcy Code did not preserve Mission’s other rights, including mere distribution rights.

Upon the completion of an extensive sales and marketing process, only two bidders attended the auction—Mission, and Schleicher & Stebbins Hotels, Inc. (“S&S”), who was both the prepetition secured lender to Tempnology and one of its largest shareholders. Ultimately, S&S prevailed as the successful bidder. Mission challenged the sale arguing, among other things, that the S&S purchase price was inferior to Mission’s bid and that the auction process was flawed and unduly influenced by S&S because of its relationship with Tempnology. After a two-day trial, the Bankruptcy Court rejected Mission’s arguments, approved the sale, and found that S&S was entitled to the protection of 363(m) as a good faith purchaser. That same day, S&S and the Debtor closed the sale.

After the sale was closed, Mission, without seeking a stay or any other judicial remedy, appealed the sale order to the Bankruptcy Appellate Panel for the First Circuit (the “BAP”) and challenged the Bankruptcy Court’s good faith ruling. Mission also appealed the order limiting its rights as a licensee of intellectual property under Section 365(n). The BAP affirmed the Bankruptcy Court’s decision on the sale order and affirmed in part and denied in part the order relating to rights under Section 365(n).

Mission took further appeal of both orders to the First Circuit.

Exclusive distribution rights are not protected by Section 365(n)

While Mission did not ultimately oppose the rejection of the Distribution Agreement, it exercised its rights pursuant to Section 365(n)(1) of the Bankruptcy Code to “retain its rights . . . to such intellectual property.” Mission interpreted the protection of this code broadly, arguing that the protections include all rights that arose under the distribution agreement, including its distribution rights.

The First Circuit rejected this argument, separating Mission’s ability to distribute product from its rights as an intellectual property licensee consistent with the terms of the contract. The First Circuit declined to expand Section 365(n)’s protection of the rights of non-debtor licensees to continue to exploit intellectual property to include protection for mere distribution rights.

Section 363(m) insulates sales from appeal

In its appeal of the sale order, Mission argued that: (i) 363(m) should not insulate a sale order from appeal even absent obtaining a stay in cases where either the “good faith” finding itself is challenged; or (ii) if the aggrieved party is deprived adequate time to seek a stay; or (iii) that the U.S. Supreme Court’s ruling in Czyzewski v. Jevic Holding Corp., 137 B.R. S.Ct. 973 (2017) argued against the good faith findings of the Bankruptcy Court.

In affirming the decision of the BAP, the First Circuit rejected Mission’s arguments and recognized the importance of the protections provided by 363(m), which provides certainty to debtors and parties that purchase assets in bankruptcy. The First Circuit found no grounds to overrule the Bankruptcy Court’s findings that S&S was a good faith purchaser within the meanings of 363(m). It further found that Mission’s due process arguments were similarly unpersuasive and that it was on notice that the Debtor had to, and was prepared to, close quickly in the event that the sale was approved. Finally, the Court held that 363(m) insulates a sale even if a sale under 363(b) was not proper. The Court did not take on the argument about the applicability of the Supreme Court’s decision in Jevic, holding that such analysis was rendered fully irrelevant at this juncture.

What you need to know

The First Circuit’s decisions have significant impact in the sale and licensing contexts for chapter 11 debtors, providing some measure of certainty to these issues moving forward. For instance:

Only expressly defined IP rights under the Bankruptcy Code and in the relevant contract survive rejection of that contract in bankruptcy;

Mere distribution rights, even if found in an agreement that provides a license for IP, are not transformed into IP rights protected under the Bankruptcy Code;

A debtor and “good faith” purchaser in a bankruptcy sale enjoy the post-sale protections of that sale found in the Bankruptcy Code free from untimely collateral attack; and

A sale closing following quickly on the heels of an order approving the sale is permitted provided that notice of a quick closing is adequate.

The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.